Financial institutions such as banks lend money to commercial borrowers (businesses) with the expectation that the cash flow of the business will generate the cash needed to repay the loan, as well as the cash needed to operate the business. The capacity of the borrower to repay the loan is thus related to its cash flow. In addition, banks usually consider the character of the borrower, which is an indicator of the effort and desire that can be expected of the buyer in repaying the loan. Banks also typically consider the collateral offered by the borrower. Collateral is a safety feature that helps to reimburse the bank in the event the borrower does not generate sufficient cash to repay the loan. Collateral is intended as a secondary, rather than the primary source of repayment.
Banks rely on the cash flow of the business for the primary source of loan repayment. Despite this, banks generally have no timely, ongoing measure of the cash flow of commercial borrowers that would permit the bank to monitor the risk of a loan repayment over its life. Moreover, banks commonly evaluate the cash flow of the borrower based on a financial statement of the borrower available at the time the bank is deciding whether to make the loan. This is not a timely means of analysis, because financial statements are typically issued about 60 days or more after the end of the period covered by the statement. Thus, the bank is likely making its loan decision based on cash flow information more than two months old superimposed by simplifying assumptions and projections.
Moreover, while the financial statement contains financial information, it may not directly provide a statement of the cash flow of the business. Thus, the financial statement may need to be analyzed to determine the cash flow. Because the cash flow information is usually out of date by at least two months, the analysis is often not done. Instead, banks commonly attempt to offset their lack of good cash flow information for the borrower by monitoring the balance in the borrower's checking account using predetermined target value(s). If the balance is less than a target value, the borrower is considered a risk with respect to its ability to repay the loan.
Evaluating the suitability of a potential borrower based on a target checking-account balance value is not an optimal means for conducting such an evaluation. For example, the checking-account balance may decrease as the cash flow of the borrower decreases, but may not to drop below the target balance. Borrowers that manage their business tightly can adjust their daily cash needs to preserve the balance above the minimum, yet may not have the capacity to repay the loan as promised.
Moreover, the checking-account balance of a business can drop below the target balance for reasons which actually reflect favorably on the financial condition of the business. For example, the checking-account balance of a business typically drops as the business's growth is accelerating. Thus, rather than reflecting an unfavorable condition, a relatively low checking-account balance in this situation can actually be a positive factor reflecting a situation that can lead to an increase in the capacity of the business to repay the loan. As another example, while a new product is being designed and built by a business, cash is consumed without a corresponding cash inflow because the product has not yet been sold or delivered. Thus, the checking account balance of the business may decrease due to a factor that will subsequently lead to an increase in the capacity of the business to repay the loan.